Growth stocks in the Nasdaq-100 (NASDAQ:QQQ) have been sold off and are now more undervalued than value stocks, and by extension the overall market (NYSEARCA:SPY). Although I can't call the bottom of the selloff and there could be substantially more downside if fundamentals worsen, the current growth selloff is already historic. Since I'm out of cash, I'm using a small amount of leverage to get more exposure to the Nasdaq-100 through ProShares UltraPro QQQ (NASDAQ:NASDAQ:TQQQ) with the hope of capturing more upside during a rebound.
I normally believe in keeping a good balance of growth and value investments. But these days many value investments are trading at fair if not elevated prices. For example, UnitedHealth (NYSE:UNH) and Walmart (NYSE:WMT) are near record high P/E ratios. On the other hand, many growth investments like Adobe (NASDAQ:ADBE), PayPal (NASDAQ:PYPL), Netflix (NASDAQ:NFLX), Facebook (NASDAQ:FB), and Google (NASDAQ:GOOG) are near the lowest P/E ratios they've had in the last five years.
While looking at historical valuations isn't necessarily indicative of the future and growth stocks are (as always) still more expensive than value stocks in absolute terms, all of the aforementioned stocks are heavily traded mega caps. So there should be some "wisdom of the crowd" baked into their valuations, and in the long term I expect some mean reversion.
Right now nobody wants to own growth stocks as they've largely guided for slowing growth rates in the midst of high inflation, rising interest rates, and a war-induced risk off environment. According to a Bank of America client survey, investors ramped up their underweight tech position to its largest level since 2006.
Overall, I agree that the current environment is not favorable to growth stocks. But I also know that the current environment won't last forever, and that the market will often turn before the fundamentals do.
For the past year, the narrative has been all about rising rates, high valuations, and inflation. But over the past few weeks, I've started to notice talk about recession for the first time. In the event that recession becomes a real risk, we'd likely see lower inflation, fewer rate increases, and more demand for increasingly scarce growth opportunities. Whether the narrative starts to shift in favor of growth now or in a few months or even years, I can't say. I'm also not saying that a recession is necessary to put growth stocks back in favor.
But the Nasdaq-100 fell 21% from peak to trough this year, and bear markets for major indexes don't happen often. Of course there could be further downside, like there was in 2000-2002, 2008, and briefly in 2020. But for long term investors, I see much more upside than downside at this point. Nobody has ever gone wrong buying during a bear market and holding for years, and bear markets deeper than -21% are very rare.
The previous section basically makes the argument that stocks have gone down, but they'll revert to the mean and go back up eventually. While that's always been true in the past, it's fair to say that just because stocks have gone down doesn't mean they're by default undervalued.
I won't try to value all 100 stocks in the Nasdaq in a single article. So, I'll use Morningstar's valuation model. Morningstar is a well-respected research firm whose five star recommendations have generated alpha in the past, indicating that their DCF-based valuation models are somewhat effective. No analyst is perfect, but Morningstar is certainly a good starting point.
Here's a chart showing the price movement implied by Morningstar in the top 25 QQQ holdings and the impact those movements would make on the index returns:
|Ticker||QQQ Weight %||MS Implied Change %||Impact On QQQ %|
Source: Morningstar, compiled by author
As shown, the top 25 holdings in the QQQ make up nearly 75% of the index and are an average of 19% undervalued according to Morningstar. Notably, most of these price targets are unchanged or even reduced from the beginning of the year, so unlike some analysts Morningstar hasn't consistently been calling stocks undervalued.
Now here's the same chart for SPY:
|Ticker||SPY Weight %||MS Implied Change %||Impact on SPY %|
Source: Morningstar, compiled by author
The S&P 500 - which is more balanced between growth and value - shows less upside in its top 25 holdings at "just" an 8% undervaluation. Notably, this entire undervaluation is coming from the Nasdaq stocks, with the NYSE-listed companies being on average fairly valued according to Morningstar. This provides some third party evidence to support my theory that the growth selloff is overdone and that growth will prove a better opportunity than value at this point.
For more of my own commentary, you can refer to my recent articles:
In general, I don't believe in timing the market. Buying slowly over time is a way to "guarantee" an average price in the long term. Although I'll usually try to DCA into stocks that I think offer the best value at the current moment, I rarely keep much cash.
I still took advantage of the recent growth selloff by selling some of my value investments in energy, financials, and healthcare to buy more growth stocks. Based on the price action in the last couple weeks, I was probably too early. But I still believe that growth stocks will generate stronger returns over the next few years, and that in the long run it's better to be too early than too late.
When steep selloffs like the -21% one happening now occur, of course I'd like more cash to buy more stocks at a discount. Research shows that it's better to be fully invested at all times, but of course adding money at the market bottom is better than adding at the top.
One way to increase exposure during a correction without saving cash for it is with leverage. It's possible to leverage yourself manually, but that comes with its own set of risks. The internet is filled with horror stories of retail investors who got margin called and had to sell everything at the worst possible time. Realistically, nobody ever got margin called using a very small amount of margin in a well diversified portfolio. But psychologically I find it easier and more convenient to let a professional leverage for me through an ETF.
Similarly, some investors like to leverage indirectly through options. But I don't like this strategy because options impose a time limit on how long it can take for the market to move in your favor.
As most investors know, leveraged ETFs increase returns to both the upside and downside. If the market continues to tank, then investing in a leveraged ETF will not be a preferable strategy, and vice versa. Furthermore, because of their higher fees, leveraged ETFs can even perform poorly in a sideways market over the long term. This risk can be reduced by holding more liquid ETFs, so the best options are leveraged ETFs for major indexes like TQQQ and SPXL (NYSEARCA:SPXL).
Since I want a leveraged ETF with high liquidity and high exposure to growth, TQQQ is the natural choice. The Nasdaq 100 isn't a perfect index, but it's a good proxy for my current growth-oriented portfolio. Both my portfolio and the Nasdaq 100 are concentrated in big tech, semiconductors, and SaaS. Although I prefer the individual stocks I picked and I don't love every stock in the Nasdaq 100, in the short term I expect similar price action from both groups of stocks. If the 18% valuation gap implied by Morningstar is closed, then TQQQ would return over 50%, and if it returned to its all-time high, then it would nearly double. I certainly wouldn't complain about those returns.
I don't want to be leveraged forever. If/when the market rebounds, I will look to exit my TQQQ position, ideally after locking in long term capital gains.
If the market continues to tank then I will likely continue to add to my TQQQ position through DCA and/or by selling regular stocks. When the QQQ went down 5% and 10% I DCA'd with the spare cash I had on hand. I started adding exposure to TQQQ around -15% and currently have a cost basis of $45.95. TQQQ now represents about 20% of my portfolio so I probably wouldn't add again unless we saw a much steeper selloff of 30% or worse.
This strategy could absolutely backfire if the market continues to trade sideways or decline for years. But in that case I will be able to DCA at significantly lower prices for years to come, which doesn't sound like a bad scenario either. This strategy certainly wouldn't be appropriate for retirees with no income but my portfolio is still relatively small compared to my income.
Although Warren Buffett probably would not advocate for using leverage to DCA, he's also said never to bet against America. The market does not look very strong right now, but it always comes back eventually.
Unless there's a catastrophic event, fundamentals favor a rebound sooner rather than later. Many of the largest growth stocks are now trading below their historical average valuations, and both analyst price targets and my own price targets imply upside. As such, I'm comfortable using a small amount of leverage to capture more of that potential upside, with the understanding that I may incur more short-term losses and fees if the market continues to tank or trade sideways.
I have a very long investing horizon, so I wouldn't mind the chance to DCA at lower prices in the coming years if the market continues to go down even more, even if that means taking a loss on my TQQQ position. But if I had to guess, I don't think I'll get that chance.
Housekeeping Note: I'll soon be launching a Marketplace service on Seeking Alpha focused in depth coverage of the best growth opportunities in today's market. The first few subscribers will get a lifetime discount, so stay tuned for an announcement next month if you're interested!
This article was written by
Kennan is a software engineer who has worked at companies of all sizes, from as large as Google to as small as a single person. He's received job offers from all of the famous FAMG companies, and graduated cum laude from the Paul Allen School of Computer Science at the University of Washington. Although not an investor by training, he enjoys applying his technical knowledge to analyze high tech companies and find investment opportunities for a long term time horizon.
Kennan runs Tech Investing Edge, a Marketplace service on Seeking Alpha. The service shares research on growth stocks in high tech industries like SaaS and cryptocurrency, combining qualitative and quantitative research with a focus on timely events and opportunities. Subscribers are able to ask questions in a chat room and request research about topics they're interested in.
Disclosure: I/we have a beneficial long position in the shares of TQQQ either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.